ans hw5 2007

Macroeconomics plus MyEconLab plus eBook 1-semester Student Access Kit (6th Edition)

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Econ 304 Sonoma State University Fall 2007 Dr. Robert Eyler Suggested Answers to Homework #5 1. The Phillips Curve is a theoretical relationship between inflation and unemployment a. Explain why the Phillips Curve is downward sloping in the short (and medium) run. The downward slope of the Phillips Curve in the short and medium runs reflects the tradeoff between inflation and unemployment, an inverse tradeoff. In the simplest sense, this tradeoff represents the scarcity of labor. This tradeoff is driven by the idea that workers are hired as a reaction to rising consumer demand for goods and services, which provides firms with profit incentives to produce more goods and services. Firms raise prices as consumer demand rises, which means the real cost of labor falls assuming that nominal wages are rigid. Nominal wage rigidity is ultimately the rationale behind the downward slope of this curve. Without it, the firm cannot enjoy the lower real cost of labor as prices rise, as workers will demand higher nominal wages as their cost of living rises. As more labor is demand and hired, unemployment falls. The reverse is also true during a recession, so-called cyclical unemployment. b. Explain why the Phillips Curve is vertical in the long run. In the long run, the assumption is that the labor market is perfectly competitive. As a result, there is perfect information between the worker and the firm concerning the movements of the labor market. If inflation takes place, real wages remain steady. Prices rise due to the increased supply of money, and workers know their cost of living will rise. Because the economy is at full employment, the only unemployed workers are frictionally unemployed; because these workers are assumed to have rational expectations, the firm must offer these workers higher nominal wages to draw them toward working if inflation is on the rise. If the firm offers higher wages, the firm has a disincentive to hire due to no change in the real cost of labor. If wages and prices move in tandem, which we assume they do under conditions of perfect information, the firm has no incentive to hire more workers. Inflation is created by policy and only inflation is created. It is a similar concept to the AS curve being vertical. The long-run Phillips Curve is vertical at the “natural rate” of unemployment, and shifts depending on the technological state of the economy. c. Explain how the expectations-augmented Phillips curve differs from the original version and why this difference may be important to policy makers. The expectation-augmented Phillips curve suggests that movements in inflation are also a
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This homework help was uploaded on 01/31/2008 for the course ECON 304 taught by Professor Eyler during the Fall '07 term at Sonoma.

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ans hw5 2007 - Econ 304 Sonoma State University Fall 2007...

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